This article has been written by Devina Srivastava, who joins The Boardroom Lawyer Team as an Associate Editor. Devina a is a final year student of the BBA LLB (Hons.) programme at Symbiosis Law School, Pune. She has an active interest in corporate law, with a special focus on corporate restructuring and governance standards.
Independent directors were ideated to be persons free from any interest in the company in an attempt to improve the corporate credibility and governance standards in India. However, the recent debacles of corporate giants such as IL&FS and DHFL have raised serious questions about the credibility of independent directors. It has often been alleged that independent directors, especially in family-owned companies, are independent only in form and not in fact. This lack of independence has been criticised for contributing to slack, corruption and nepotism in organisations, ultimately leading to corporate failures.
To check unethical practices in relation to appointment of independent directors, the Ministry of Corporate Affairs (“MCA”), Government of India, on 22nd October, 2019, notified the Companies (Appointment and Qualification of Directors) Fifth Amendment Rules, 2019, the Companies (Accounts) Amendment Rules, 2019 and the Companies (Creation and Maintenance of Databank of Independent Directors) Rules, 2019, that became effective on 1st December, 2019.
In this post, I seek to broadly discuss the changes introduced in the legal regime concerning the appointment of independent directors, and highlight the ambiguities persisting in them. I also seek to call attention to the insufficiency of the measures introduced by the new rules in ensuring better corporate governance.
New Rules for Independent Directors
The concept of having a data bank of persons eligible to be appointed as independent directors was first introduced through section 150 of the Companies Act, 2013. In its latest bid to effectively implement this provision, the MCA notified the Indian Institute of Corporate Affairs (“IICA”) as the agency for maintaining the data bank. Now, a person who has been appointed as an independent director as on 1st December, 2019, or who intends to get appointed as an independent director, is now required to apply to the IICA for inclusion of his name in the ‘Data Bank of Independent Directors’. Further, persons whose names have already been included in the data bank must apply for renewal within 30 days from the date of expiry of the period for which their name was included. Within one year of inclusion of name in the data bank, the applicant must pass an online proficiency test that would assess his/her knowledge of company law, securities law, accountancy and other relevant areas. In case the individual fails to pass the test within the stipulated period, his/her name would be removed from the data bank.
Further, through the Companies (Accounts) Amendment Rules, 2019, it has been provided that a company’s Board Report must contain a statement regarding the opinion of the board on the integrity, expertise and experience of its members. It has been provided that experience here includes proficiency, which is assessed through the test conducted by IICA. Thus, the onus of ensuring that the independent directors have passed the proficiency test lies on the company appointing them.
These amendments are aimed at ensuring that independent directors have sufficient knowledge and expertise, so that they may not allow themselves to be manipulated, and better perform their duties.
Ambiguities in the New Rules
The new rules are fraught with a number of ambiguities that require clarity. First, the rules do not provide for the consequences of not complying with several provisions. For instance, it is unclear as to what will be the consequence of independent directors not applying to have their names included in the data bank. It is provided that in case of an individual who fails to pass the test, within the stipulated period of 12 months, his/her name shall be removed from the data bank. However, consequences of not applying for inclusion of name in the data base itself, are not provided. Similarly, no consequence is provided in respect of persons whose names have already been included in the data bank and who fail to file an application for renewal or pass the proficiency test thereafter. Furthermore, the consequences of non-inclusion of a statement regarding the opinion of the board on the integrity, expertise and experience of its members in the Board’s Report, are unclear. The language of the rule is ambiguous in as much as it does not clarify whether this is merely a disclosure requirement or its non-observance would result in any penalties for the company or its members.
Second, it has been provided that if a person has served as a director or KMP, for a 10 year period, in a listed public company or an unlisted public company having a paid-up capital of at least Rs. 10 crores, he/she would be exempt from the requirement of taking the proficiency test. As per the rules, this 10 year period is to be computed on the ‘date of inclusion’ of the person’s name in the data bank. However, the FAQs provide that if an individual attains the requisite experience ‘during the course of the year or at any time later’, he/she will be exempt from taking the test. Thus, as per the FAQs, a person will be exempt from taking the test if he attains the required experience even after inclusion of his name in the data bank and before he has taken the test. This is in clear conflict with the provisions of the rules.
Third, the question of whether every independent director must mandatorily be included in the databank is a dubious one. Section 150 of the Companies Act, 2013 provides that an independent director ‘may’ be selected from the data bank. Thus, the requirement of appointing an independent director from the data bank cannot be said to be a mandatory one. By now mandating that every independent director be included in the data bank, the rules run the risk of exceeding the statutory provision that they emanate from.
Will Independent Directors be Truly Independent Now?
The rules are certainly well-intentioned in so far as they strive to educate independent directors and make them aware of their responsibilities. However, the effectiveness of the rules in achieving their intended objective is doubtful.
The courses available on IICA to assist in preparation for the proficiency test only cover law-based topics such as companies law, securities law, and different case studies. They are deficient in covering topics such as accountancy and finance. Further, directors of different companies need different skills, depending upon the nature of company, business sector concerned, etc. Thus, one standardised test does not meet the exigencies of the profession. The test has also been criticised for neglecting the need for directors to continually update their knowledge.
Furthermore, the test may contribute towards the dwindling numbers of available independent directors. Statistics show that in comparison to a total of 606 independent directors who resigned from NSE-listed companies in 2018, a whopping 412 independent directors had already resigned from January to July in 2019. If the rules are enforced strictly, many directors would become ineligible and consequently, the pool of independent directors would further shrink.
Most importantly, the ability to act effectively as independent directors comes through experience and a sense of responsibility – neither of which can be ensured by a test. Giant corporates such as ICICI Bank and IL&FS, which had extremely well-qualified and imminent persons as independent directors, have also come under the scanner for corporate malpractices. The real issue that requires attention is the lack of accountability of independent directors and serious lapses in the legal regime governing them, such as the lack of powers conferred on them. Thus, corporate governance cannot be ensured by merely appointing persons who have passed a test. It may be due to this that no other leading corporate law jurisdiction has prescribed such a requirement to assess suitability of independent directors.
Summing up, the new rules not only lack clarity in a number of respects but also are deficient in addressing the key issues concerning independent directors. Though a minimal level of literacy in matters of corporate governance is a must, independent directors need to be more than passive observers of a company’s affairs. The need is to transform them into active participants by empowering them to act in the interest of the company and its members. A mere test of knowledge would not suffice for this purpose.